Dollar, Bond Yields and Dow All See Major Losses: Is This THE Turn?
With no economic data released today, the only thing that could rattle the currency markets was a reversal in US stocks. Not only did a reversal actually occur, but bond yields also fell sharply, triggering major losses in the both the US dollar and carry trades. Many people may be wondering, what happened? There were rumors that a German bank will be reporting large subprime losses and also talk that Standard and Poor’s could be downgrading European mortgages. The contagion effect warned by Fed Chairman Ben Bernanke earlier this week has now become global, which is clearly too much for speculators to handle. Banks on Wall Street are reporting that hedge funds are bailing out of USD/JPY big time, which explains the sharp move in the currency pair today. Ten year bond yields broke below the psychologically important 5 percent mark, leaving the curve relatively flat at the moment. The triple digit losses in the Dow could extend for at least a few more days which lead us to wonder whether this is THE turn in the markets. Possibly. Bernanke made a mild but clear shift in his outlook for the economy and monetary policy this week. He has warned about the subprime sector and if a German bank truly reports a big loss as rumored, then a rise in risk aversion is certainly warranted. With the subprime sector being watched so closely, next week’s reports of existing, new and pending home sales will be particularly market moving. Should the rumors about the German bank prove unfounded and the housing data fails to show further deterioration, do not be surprised to see a return of risk appetite. The market’s tolerance for risk over the past few months has been far greater than anyone may have initially anticipated. Looking ahead, aside from the housing market reports, we are also expecting the Beige Book release, durable goods and the advance release of second quarter GDP. It should continue to be an exciting trading week.

Euro Headed Towards 1.40?
The Euro climbed to a new record high today, putting 1.40 within arm’s reach. Like the US, there was no major economic data released, which means that the move higher was solely driven by subprime related dollar weakness. The biggest question on the minds of Euro traders is whether this will matter for the European Central Bank, who will be meeting to discuss monetary policy in 2 weeks. Judging from the recent comments made by ECB President Trichet and his peers, it will not. Earlier this week, Trichet has warned European politicians that interference into their monetary policy decisions will be a breach of the EU treaty. He may not want to talk down the Euro anytime soon because that may be misinterpreted as giving into political pressure. Furthermore, not only has ECB Garganas indicated that further rate hikes are likely, but this morning, Constancio said that they have no target for the exchange rate. Unlike back in December 2005, Germany, the Eurozone largest member country is better equipped to handle a stronger currency. Therefore if the ECB does step in to stop the Euro’s rise, it would certainly be a blow coming from the left field. Looking ahead, the most important pieces of data on the Eurozone calendar are EZ PMI, M3 and the German IFO survey. Steady or softer figures are expected all around. Meanwhile Swiss producer prices were much softer than the market expected in June, but this has not affected the value of the Franc. Next week, we are expecting the KoF report of leading indicators.

Carry Trades: Is This Profit Taking or Liquidation?
Japanese Yen crosses or carry trades have sold off significantly today, raising the question of whether this is finally liquidation or just another bout of profit taking. The gap between Japanese and US bond yields has been narrowing with Japanese Yields holding steady and US yields selling off aggressively, which suggests that market sentiment has changed. For USD/JPY we have seen weakness throughout the past week and further losses are of course contingent upon whether the problems in subprime become global. The degree of today’s move reminds us of the move that happened in early June which means that it could extend for a few more days next week. There is enough on the US and Japanese calendar next week to prove to us whether the markets have really turned. From Japan, we are expecting consumer prices and retail sales.

British Pound Hits New 26-Year High on Stronger GDP Growth and Dollar Weakness
The British pound surged to a fresh 26 year high on the back of overall dollar weakness and stronger second quarter GDP growth. A rise in oil extraction in the North Sea provided an unexpected surprise to GDP growth. With the market so bullish British pounds to begin with, stronger growth will only give those looking for another rate hike greater confidence. The futures curve is still pricing in 6 percent interest rates by the end of the year, but the question is whether this will come in the third or fourth quarter. Last week’s less hawkish minutes suggests the latter and unless we get some surprising comments from BoE officials, we will not get much more clarity next week. The only pieces of data on the UK economic calendar are house price reports and CBI Industrial trends survey.

Commodity Currencies End Week at Multi-Year Highs
The Australian, New Zealand and Canadian dollars performed extraordinarily well this week. The Aussie and Kiwi actually both hit new multi year highs today before giving back their gains. Import and export prices from Australia rebounded in the second quarter even though the annualized pace of growth in Australia saw the biggest drop in 3 years. New Zealand on the other hand reported a sharp jump in credit card spending, which indicates that consumer demand is still strong. Looking ahead we are expecting inflation data from Australia, an interest rate decision from New Zealand and retail sales from Canada. Expect it to continue to be a busy week.

Kathy Lien is the Chief Currency Strategist at FXCM.